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Optimal Ramsey Taxation in Heterogeneous Agent Economies with Quasi-Linear Preferences

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Abstract

We build a tractable heterogeneous-agent incomplete-markets model with quasi-linear preferences to address a set of long-standing issues in the optimal Ramsey taxation literature. The tractability of our model enables us to analytically prove the existence of the Ramsey steady state and establish several novel results: (i) The failure of the modified golden rule (MGR) cannot by itself justify a positive steady-state capital tax---we prove that in the absence of wealth-redistribution effects the optimal capital tax is exclusively zero in the Ramsey steady state regardless of the validity of the MGR. (ii) The optimal capital tax is positive only along the transition path, and it depends positively on the elasticity of intertemporal substitution. (iii) The optimal debt-to-GDP ratio, however, is determined by a positive wedge times the MGR saving rate. The key insight behind our results is that in the absence of any wealth-redistribution effects, taxing capital in the steady state cannot eliminate the liquidity premium---the primal friction in the model---but instead permanently erodes individuals' buffer-stock savings and self-insurance position; thus, the Ramsey planner opts to issue debt rather than impose a steady-state capital tax to correct the capital-overaccumulation problem. Also, the MGR fails to hold in a Ramsey equilibrium whenever the government encounters a binding debt limit; but even in this case the optimal capital tax is zero, suggesting that it is more distortionary than a labor tax in financing the interest costs of public debt. Therefore, if there is a reason to tax capital in the Ramsey steady state, it may have something to do with the tax's effect on wealth redistribution rather than on the failure of the MGR due to capital overaccumulation.

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  • YiLi Chien & Yi Wen, 2019. "Optimal Ramsey Taxation in Heterogeneous Agent Economies with Quasi-Linear Preferences," Working Papers 2019-007, Federal Reserve Bank of St. Louis, revised 24 Apr 2021.
  • Handle: RePEc:fip:fedlwp:2019-007
    DOI: 10.20955/wp.2019.007
    Note: Revision of WP 2017-024, Optimal Ramsey Capital Income Taxation—A Reappraisal https://doi.org/10.20955/wp.2017.024
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    References listed on IDEAS

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    1. François Le Grand & Xavier Ragot, 2017. "Optimal Fiscal Policy with Heterogeneous Agents and Aggregate Shocks," Sciences Po Economics Discussion Papers 2017-03, Sciences Po Departement of Economics.
    2. Sebastian Dyrda & Marcelo Pedroni, 2015. "Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Shocks," Working Papers tecipa-550, University of Toronto, Department of Economics.
    3. Yunmin Chen & YiLi Chien & C.C. Yang, 2017. "Implementing the Modified Golden Rule? Optimal Ramsey Capital Taxation with Incomplete Markets Revisited," Working Papers 2017-003, Federal Reserve Bank of St. Louis, revised 01 Oct 2020.
    4. Aiyagari, S Rao, 1995. "Optimal Capital Income Taxation with Incomplete Markets, Borrowing Constraints, and Constant Discounting," Journal of Political Economy, University of Chicago Press, vol. 103(6), pages 1158-1175, December.
    5. Ljungqvist, Lars & Sargent, Thomas J., 2012. "Recursive Macroeconomic Theory, Third Edition," MIT Press Books, The MIT Press, edition 3, volume 1, number 0262018748, December.
    6. Emmanuel Farhi, 2010. "Capital Taxation and Ownership When Markets Are Incomplete," Journal of Political Economy, University of Chicago Press, vol. 118(5), pages 908-948.
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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Don’t Tax Capital — Optimal Ramsey Taxation in Heterogeneous Agent Economies with Quasi-Linear Preferences
      by Christian Zimmermann in NEP-DGE blog on 2019-03-21 16:04:46

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    Cited by:

    1. Chari, V.V. & Nicolini, Juan Pablo & Teles, Pedro, 2020. "Optimal capital taxation revisited," Journal of Monetary Economics, Elsevier, vol. 116(C), pages 147-165.
    2. Odran Bonnet & Guillaume Chapelle & Alain Trannoy & Etienne Wasmer, 2019. "Secular Trends in Wealth and Heterogeneous Capital: Land is Back... and Should Be Taxed," Sciences Po publications 2019-14, Sciences Po.
    3. YiLi Chien & Yi Wen, 2019. "The Determination of Public Debt under both Aggregate and Idiosyncratic Uncertainty," Working Papers 2019-038, Federal Reserve Bank of St. Louis, revised 13 Aug 2020.

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    More about this item

    Keywords

    Incomplete Markets; Ramsey Problem; Optimal Capital Taxation;
    All these keywords.

    JEL classification:

    • E13 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Neoclassical
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General

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